Suppose the economy is operating at the Zero Lower Bound for the nominal policy rate, the economy is operating at the potential output in period 't,' but there is a large government budget deficit. A newly elected government vows to cut spending and reduce the deficit in period 't+1,' period 't+2,' and subsequent periods. Use an IS-LM-PC diagram and words to answer the following questions. A) What is the effect of the policy on output in period t+1?
B) What is the effect of the policy on the change in inflation in period t+1?
C) If expected inflation depends on past inflation, when what happens to the real policy rate in period t+2? How will this affect output in period t+3?
D) How does the ZLB on nominal interest rates make fiscal consolidation more difficult?